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Intermediate Accounting: Reporting...

3rd Edition
James M. Wahlen + 2 others
ISBN: 9781337788281

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Intermediate Accounting: Reporting...

3rd Edition
James M. Wahlen + 2 others
ISBN: 9781337788281
Textbook Problem
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Ethics and Share Options

Smaller Corporation has been in operation for several years. Each year, around the holidays, Smaller gives a cash bonus to each of its employees and records the bonuses as compensation expense. Smaller has reached the point at which it is now making a reasonable return on its shareholders’ equity. At the end of the current year, the company president is considering establishing a compensatory share option plan for Smeller’s key executives, instead of paying cash bonuses to any of its employees. At this time, the market price and the planned option (exercise) price of the company’s common stock are the same. The plan would allocate a specified number of options to each executive based on the executive’s level within the company and meeting Smeller’s targeted income goals. The service period would be 3 years and the options would have to be exercised within 10 years.

You are the controller for Smaller and one of the key executives who would participate in the plan. You also already own a substantial number of shares of smaller common stock. The company president comes to you for advice about this plan and says, “If Smaller establishes this plan, it will work out for all of us. It looks like the plan is pretty valuable, since an option pricing model shows a high fair value for each option. The corporation will be saving cash because it won’t have to pay bonuses to either the executives or the other employees. But executives will manage better because their share options will depend on meeting the company’s targeted income. Because the market price and the option price are the same, there won’t be any compensation cost or expense related to this plan. Furthermore, since no bonuses would be paid to any employees, the corporation will decrease its compensation expense. This will increase its net income and earnings per share compared to last year, as well as its return on shareholders’ equity. So the stock value will go up. This seems like a win-win situation for everyone. Am I right on this?” Do you think Smaller should adopt this compensatory share option plan?

Required:

From financial reporting and ethical perspectives, how would you reply to the president?

To determine

Explain the manner Person Y reply to the president of Corporation S from financial reporting and ethical perspectives.

Explanation

The president of Corporation S is wrong from the financial reporting perspective. Because, Corporation S must recognize the Compensatory cost on performance based share option plan on the estimated fair value of the options on the date of exercise. The total fair value of the shares that actually exercised is the total compensation cost. Corporation S does not recognize the total compensatory cost on its financial statements as on the date of grant. Instead, it recognizes it as a compensation expense over the required service period using the straight line method. Thus, the corporation’s total compensation expense will be higher each year by the amount related to the share options. Whether this amount would be more or less than the amount that would have been paid as bonus depends on the fair value of the options and bonus foregone by the executives and the other employees. In any case, disagreeing to what the president said, there is an effect on the income statement and on earnings per share by the share option plan. But it is true that Corporation S can save the cash by not paying bonus to its employees in short run.

There are two issues from ethical issues.

1) Whether the president of a corporation should be considering “managing” the income and earnings per share by substituting the compensatory share option plan for cash bonus.

2) Whether the president should be substituting the compensatory shares plan for key executives, while eliminating the cash bonus to all the employees. The stakeholders of the corporation include Person Y, executive employees, non-executive employees, and shareholders.

Regardless of whether Person Y and other executives will be "better managers" will rely upon whether each one of the executives is persuaded more by the potential for getting Cash bonus or by the capability of having the capacity to buy the organization's stock at a "bargain price"...

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